Difference between ROCE and ROIC and does it matter

Financial metrics and investment quality

Deciphering financial ratios can be daunting for investors looking to differentiate potential investments on quality. But if you’re set on picking your own investments, then you need to be able to understand and interpret them. If there are better ways you could be spending your time, then leave it a mutual fund manager in spite of its drawbacks or even just buy a low-cost index tracker, which tends to beat most active investors anyway.

When it comes to financial metrics, it’s important to

understand the spirit more than the letter of the metric, i.e. what the metric is meant to convey about the strength (weakness) of the business. e.g. consistently high gross profitability is an indicator of persistence in pricing power while volatility in this metric suggests otherwise

be aware of what it leaves out as much as what it includes. e.g. two companies with equally high EBITDA margins might be starkly different investments on account of their capital investment needs

watch out how (easily) it might be gamed. e.g. metrics lower down on the Profit & Loss statement are more easily “dressed up” compared to those on cash flow statements. Also a reason why earnings per share is a poor metric to rely on

This short post addresses the distinction between two similar-sounding return metrics, ROCE and ROIC, that are different in a subtle yet important manner.

Return metrics over Profit metrics

Both return metrics ROCE & ROIC, are better than P&L profit metrics as indicators of how productively the company uses capital to generate profits.

Imagine two restaurants, both generating ₹1Cr EBITDA on sales of ₹5Cr, except restaurant A invested ₹50Cr to buy kitchen equipment and furniture while B only invested ₹10Cr to refresh the decor of an already equipped place that it leases. Each ₹ of capital in A returns ₹0.02 (2%) while in B returns ₹0.10 (10%).

Now imagine both are looking to expand, and so need to raise fresh capital of ₹50Cr. A will need to use all that money to open one more restaurant while B’s model will allow it to open five more restaurants. The snowball effects on revenue and profits show why return on capital metrics are powerful indicators of future returns.

How ROCE and ROIC differ

Textbook definitions

ROCE = Net Operating Profit / Capital Employed

ROIC = Net Operating Profit / Invested Capital

The numerators are identical. It’s the difference between “Capital Employed” and “Invested Capital” that’s key to what these metrics tell us and leave out. Interestingly different sources vary slightly on how they calculate both these measures by choosing to include or exclude specific items. Here’s how I’ve understood them (experts please weigh in if I’ve got these completely wrong)

Capital Employed is the umbrella term that implies ALL the capital that’s part of the business, from equity and debt holders less short term liabilities. If it’s “in the business”, then it gets counted as capital employed to generate returns

Invested Capital is the portion of capital actively being utilized in the business. It is therefore capital employed less non-operating assets like cash & cash equivalents, investments outside of the business (like securities of other companies) and any assets that were part of operations no longer active.

“Invested Capital” is therefore a subset of “Capital Employed”.

Both are measures of how well management utilises assets at its disposal, ROCE takes a longer-term view of it’s ability to do so since it penalises managements for holding too much cash for too long, while ROIC normalises comparison between companies in a sector to compare productivity of operating assets.

Most reports tend to publish ROCE which works well as a metric. It’s when they are used together that we need to be aware of how they differ, like this excerpt from a Motilal Oswal report on TCS:

Cash, investment and ICDs at INR335b keep RoCE muted:

Over the past five years, the company has allocated 28% of its

funds toward cash, investments and ICDs (yield: 6.8%). This

has constrained RoCE to 42% which is still best among the

industry, though well below impressive RoIC of 71%

The important thing is not to get bogged down with too many ratios but to use the key ratios consistently over time to compare potential investments.